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Misery may be just beginning, warns IMF

By Edmund Conway, Economics Editor
Last Updated: 12:16am BST 25/09/2007

 Misery may be just beginning, warns IMF
The US housing market faces further falls
if credit market problems persist

Even when the financial waters are calm, the International Monetary Fund's Financial Stability Report can make for worrying reading. When markets are in the midst of a major crisis, it can be extremely disturbing.

The message from the latest of these risk assessments is that this crisis is no flash in the pan. The likelihood of further market crunches has increased significantly, it said. Even if these do not occur, there will still be major knock-on effects on the economy.

Jaime Caruana, chief author of the report, said: "After a long period of benign conditions, the financial system is enduring a significant test. This has important implications for the economy. We expect that the process of adjustment will be protracted and there will be implications in terms of the lessons that need to be drawn. There may be some regulatory changes which need to be examined."

He predicted a slowing of the global economy's growth, and said it could help to push up inflation, as markets realise that money is likely to be considerably more expensive in the future.

The report was even more foreboding, saying: "The consequences of this episode should not be underestimated and the adjustment process is likely to be protracted. Credit conditions may not normalise soon, and some of the practices that have developed in the structured credit markets will have to change."

The probability of major financial institutions defaulting has risen dramatically, as jittery investors withdraw money from the market.

With the crisis having originated in the US, all eyes are now on the American property market. The report warned that problems in the credit markets could push US property prices even lower, while the world economy will suffer if the high interest rates in credit markets persist.

"The chances of more severe tightening of credit conditions cannot be dismissed," it said. "Such a tightening could have significant global macro-economic consequences, with the incidence of such tightening falling most heavily on more marginally creditworthy borrowers." Meanwhile, the sub-prime crisis is likely to last "at least through 2008", with more families defaulting as the low introductory "teaser" rates rise, the report said. It added that even if house prices fall only 5pc and then stabilise, losses from the sub-prime defaults would still reach $170bn (£84bn), with a quarter of this lost by banks and the remainder by holders of mortgage-backed securities.

Misery may be just beginning, warns IMF

In its latest update of its economic forecasts next month, the IMF is expected to slash its forecast for US economic growth next year – perhaps to as low as 1pc-1.5pc.

Although the crisis has mainly affected US and European markets so far, developing economies are also at risk. In some countries, banks have borrowed abroad in foreign currencies to lend domestically, and with little capital to rely on they are vulnerable to the problems in Western credit markets.

The assessment – given extra weight as the IMF is notoriously conservative with its forecasts – will be a major disappointment to many in the markets who expected a quick recovery.

The report said the crisis stemmed in part from three key weaknesses:

• Uncertainty and poor information about the risks associated with complex financial instruments. Greater transparency is needed.

• Globalisation has meant crises spread faster around the world since, for example, US mortgage debt is owned by investors from Germany and the UK to China and Australia.

• Investors have become over-reliant on ratings agencies which grade various debt instruments. It concluded the agencies should introduce a special ratings scheme for complex structured credit instruments – the products at the centre of the turmoil. It added that institutional investors "must ensure their investment mandates do not lead to an over-reliance on agency letter ratings, and that they do not (implicitly) delegate the job of examining complex assets to ratings agencies."

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